So I read about an interesting proposal about completely replacing income tax with a heavy national sales tax of about 30% (23% inclusive to compare to income tax).

I was thinking about what the impact of this would be. On one end, income goes up both because people would want to work more and they get to keep everything they earn.

On the other end, prices go up because of the sales tax. I was also learning that spending is crucial for short term economic growth, so that may hurt. But does the laffer curve apply to sales tax as well? People may buy more frequently if it went down, increasing tax revenue. I know the laffer curve is unreliable, but it was just a thought.

Is this thinking process correct, or would the fair tax be a complete disaster? I apologize I just got interested in economics so I don't know much.

3 Answers
3

Well, one advantage to a sales tax is that it affects everyone (even those who don't pay income taxes). However, some people may see that same fact as a problem. This problem lies in analysis of the equity of the tax. When we consider every single person being taxed 30% on everything they buy, we need to think about how that affects different income groups. Lower income groups spend a much larger portion of their income on consumption, which means that they will be taxed relatively much more heavily than high income groups. This fact alone is enough to discourage this sort of action because the government tries to encourage saving in the lower income groups (so they can move up to higher income levels). This is one large reason why a tax like this may not be as fair as the name makes it seem.

Another piece of information that must be considered is the incidence of the tax. As we know, the incidence of a sales tax depends upon the relative own-price elasticities of supply and demand. This means that in a market with very inelastic demand (such as cigarettes or oil), the buyer is paying most of the tax whereas in a market with elastic demand the sellers would pay most of the tax. This fact would make it so that different industries would end up paying a different amount of the sales tax compared to one-another. For example, an oil company would end up paying much less of the percentage of the tax than a company making a selfie stick. This, again, seems to be unfair.

A) The idea is to think about the equilibrium of an economy with a particular tax system. For example, in equilibrium a change from income taxes to consumption taxes doesn't necessarily change prices or consumption one way or the other. Intuitively, firms would lower the price because they no longer have to pay income taxes, but the prices would increase because of the direct consumption tax.

B) All practical taxing systems generate inefficiencies and have unequal incidence across consumers and industries. Therefore, a first order issue is which system generates less inefficiency or which one is the least unfair. In some scenarios, ´lump sum´ taxes, that don´t distort marginal incentives are optimal: for example a per-person flat tax for anybody living in the US would not be distortionary because it does not change the cost or benefit of any activity. (Good luck with implementing that politically!)

C) Unfairness in taxation can, in principle, be undone for example with tax credits, need based transfers, etc. We do a lot of this already in the US code and most others. The cost of this is that it increases the complexity in the tax code and increases the costs of compliance and fiscalization.

D) A crucial consideration is which tax is more collectable. Income tax is very collectable because its easy to observe wages paid and profits obtained by corporations. However, much of consumption is retail-level and therefore high consumption taxes often lead to high tax-avoidance, specially in places where the rule of law is less than perfect. Another collectable tax is one where agents have an incentive to collect from each other: the VAT tax systems aim to crate this by making it possible for agents to expense VAT taxes paid a with VAT taxes charged...

FairTax is not intended to increase or decrease the taxation rate, therefore costs of products should stay roughly the same. For example, without income tax, a family might keep 10% more of their income and prices might fall 20%. But then purchases are taxed at 30% and the net cost to a family remains the same. The only exception is the cost of compliance, which would be eliminated (goodbye 70k pages of tax code), and would lower costs overall. You can see more about this from a study conducted by Dale Jorgenson.

Laffer Curve applies, but again, the FairTax is not intended to increase or decrease taxes. Therefore, the question of whether taxes should be increased or decreased for short term economic growth (or some other reason) is a question for taxation as a whole and is not related to the FairTax specifically. FairTax rate may be increased or decreased by congress just as any other tax.

A little more on compliance costs: The Tax Foundation estimates that, "Americans spent over 3.24 billion hours, which is about 369,858 years, preparing and filing tax returns in 2012. Considering individual, business and employment taxes, this costs $37 billion annually in compliance cost for federal taxes alone." The FairTax essentially eliminates this waste.

Debunking some of the other responses:

"Lower income groups spend a much larger portion of their income on
consumption, which means that they will be taxed relatively much more
heavily than high income groups."

Not only is this conclusion false, but the converse is true. Under the FairTax, a prebate would ensure that those at poverty level would pay zero tax. Under the FairTax, lower income groups would be taxed very little (if at all). https://www.youtube.com/watch?v=UPm9BaihZIM

an oil company would end up paying much less of the percentage of the
tax than a company making a selfie stick. This, again, seems to be
unfair.

This is also false. Under the FairTax, all businesses pay zero tax. Businesses collect the tax and are compensated for the cost of collecting the tax. This ensures the taxes are paid fairly by individuals and the "incidence of tax" is not applicable.

$\begingroup$A "fair tax" is not the same as FairTax which seems to be something quite different. Also the sources of all claims in this answer seem to be a single advocacy group which is rarely fortunate.$\endgroup$
– GiskardAug 30 '16 at 16:29